Why is total market weighted index best?

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JBTX
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Why is total market weighted index best?

Post by JBTX »

While I totally buy into indexing, and generally buy into market weighting, what is the positive / theoretical reason why market weighting is the best choice, in terms of risk adjusted equity returns (let's stick with domestic for this argument)

I understand the counter positive arguments

- why not the market weighted index?
- what is better than the market weighted total index?
- if not market weighting, then what?

I understand the behavioral, in that if your return lags the total market index, you will be tempted to revert to the total market index and permanently lock in historical under performance.

But I'm looking for positive arguments. Why is a total market weighted index the best choice?

Why is it better than an equal weighted index (which is a different animal, more small mid cap and probably more value tilt)

Why is it better than a total market plus tilts?

Ultimarely it doesn’t feel like an index that is 25%, give or take, concentrated in 10 securities feels very diversified.
boglerdude
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Re: Why is total market weighted index best?

Post by boglerdude »

Millions of people are studying companies, pricing the stocks. They get it close enough to exactly right.

With cap weighting, you buy the same % of every company. eg you'll own 1% of Al's tofu stand and 1% of Apple.
Swivelguy
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Re: Why is total market weighted index best?

Post by Swivelguy »

> Why is market cap weighted better than equal weighted?

For one, because a market-cap weighted index fund barely has to trade at all, while an equal-weighted index fund has to trade constantly. This no doubt would add some drag due to transaction costs, not to mention being a huge problem in a taxable account. Secondly, when a company on the smaller side fails, an equal-weighted index fund that is attempting to hold at all times $1M of that company's stock will continue to buy it and buy it as the price drops, until that fund holds all of the shares outstanding in a completely worthless stock. Meanwhile in the market-cap-weighted index, the failure of this smaller company is barely felt.

> Why is total market better than tilts

Well, the tilts either win or they don't. Crystal ball, etc, etc.
TheDDC
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Re: Why is total market weighted index best?

Post by TheDDC »

JBTX wrote: Tue May 12, 2020 10:37 pm While I totally buy into indexing, and generally buy into market weighting, what is the positive / theoretical reason why market weighting is the best choice, in terms of risk adjusted equity returns (let's stick with domestic for this argument)

I understand the counter positive arguments

- why not the market weighted index?
- what is better than the market weighted total index?
- if not market weighting, then what?

I understand the behavioral, in that if your return lags the total market index, you will be tempted to revert to the total market index and permanently lock in historical under performance.

But I'm looking for positive arguments. Why is a total market weighted index the best choice?

Why is it better than an equal weighted index (which is a different animal, more small mid cap and probably more value tilt)

Why is it better than a total market plus tilts?

Ultimarely it doesn’t feel like an index that is 25%, give or take, concentrated in 10 securities feels very diversified.
I chose to market cap weight (VTSAX) but have shifted half of my domestic allocation to Vanguard growth index (VIGAX) about two weeks ago. I do not believe a passive index alone is always 100% the way to go. While I am bullish on a recovery, quite possibly occurring by end of year, I believe that growth stocks will lead the way. In making this decision I did not consider the current circumstance in isolation. For most decades, growth has led the way.

I will continue to reassess, but considering VTI/VTSAX is also categorized as “large growth” on the style matrix or even “growth+income”, tiling toward growth a tad more is not veering too bad off the path in my view. It’s not like piling it all in the cubes.

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Rules to wealth building: 75-80% VTSAX piled high and deep, 20-25% VTIAX, 0% given away to banks, minimize amount given to medical-industrial complex
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randyharris
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Re: Why is total market weighted index best?

Post by randyharris »

JBTX wrote: Tue May 12, 2020 10:37 pm While I totally buy into indexing, and generally buy into market weighting, what is the positive / theoretical reason why market weighting is the best choice, in terms of risk adjusted equity returns (let's stick with domestic for this argument)

I understand the counter positive arguments

- why not the market weighted index?
- what is better than the market weighted total index?
- if not market weighting, then what?

I understand the behavioral, in that if your return lags the total market index, you will be tempted to revert to the total market index and permanently lock in historical under performance.

But I'm looking for positive arguments. Why is a total market weighted index the best choice?

Why is it better than an equal weighted index (which is a different animal, more small mid cap and probably more value tilt)

Why is it better than a total market plus tilts?

Ultimarely it doesn’t feel like an index that is 25%, give or take, concentrated in 10 securities feels very diversified.
You can find periods of time when equal weighting outperforms. In my opinion Market Cap weighting is more favorable though, because in effect you have more riding with the successful companies and as the losers fall back and eventually out of the index, along that path they become a smaller and smaller allocation of the overall index.
DonIce
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Re: Why is total market weighted index best?

Post by DonIce »

JBTX wrote: Tue May 12, 2020 10:37 pm While I totally buy into indexing, and generally buy into market weighting, what is the positive / theoretical reason why market weighting is the best choice, in terms of risk adjusted equity returns (let's stick with domestic for this argument)

I understand the counter positive arguments

- why not the market weighted index?
- what is better than the market weighted total index?
- if not market weighting, then what?

I understand the behavioral, in that if your return lags the total market index, you will be tempted to revert to the total market index and permanently lock in historical under performance.

But I'm looking for positive arguments. Why is a total market weighted index the best choice?

Why is it better than an equal weighted index (which is a different animal, more small mid cap and probably more value tilt)

Why is it better than a total market plus tilts?

Ultimarely it doesn’t feel like an index that is 25%, give or take, concentrated in 10 securities feels very diversified.
There isn't really a strong affirmative reason, besides that the costs are lowest. It's more like a solid default option that should minimize regret for most people.

If you have a strong belief in adding tilts, or equal/fundamental weighting, etc, those are also reasonable things to do provided you understand what you are doing. Plenty of people here advocate for tilts.

The reality is no one knows which strategy will provide the best "risk adjusted equity returns" in the future. People only know the past, and the future of financial markets is not predictable.
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JBTX
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Re: Why is total market weighted index best?

Post by JBTX »

thanks for the replies.

To take it a step further. There is a negligible difference between total market index and s&p 500. Thus the bottom 4500 (or whatever the real number is) are essentially irrelevant. By extension, it is better to own the top 10-15 companies vs the bottom 4500.
DonIce
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Re: Why is total market weighted index best?

Post by DonIce »

JBTX wrote: Wed May 13, 2020 1:40 am thanks for the replies.

To take it a step further. There is a negligible difference between total market index and s&p 500. Thus the bottom 4500 (or whatever the real number is) are essentially irrelevant. By extension, it is better to own the top 10-15 companies vs the bottom 4500.
Taking it down to 10-15 is probably too few. But the top ~30 is close enough, as can be seen by the correlation between the Dow and the S&P500.
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JoMoney
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Re: Why is total market weighted index best?

Post by JoMoney »

There is no other way to divide the market up and create a "better" portfolio by some particular criteria without also creating a remaining portfolio that's worse. If markets work, prices will move towards an equilibrium.
You might be able to find some people that prefer to hold a less-risky portfolio (with less concern about returns), and others who prefer higher returns (with less concerned about risk), in aggregate they must hold the 'Total Market' combined but in a differently weighted fashion, as long as each prefers their portfolio as being "best" based on different individual preferences at that price... but they have to be measuring it using different criteria. If you set their criteria for being "best" to use the same measurement, like "best risk adjusted return", the only way to divide the portfolio up in equilibrium is market-weighted. If you presume most investors want the best "risk adjusted returns", prices in the market will adjust as people buy and sell until something close to an equilibrium is found.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham
whereskyle
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Re: Why is total market weighted index best?

Post by whereskyle »

JBTX wrote: Tue May 12, 2020 10:37 pm While I totally buy into indexing, and generally buy into market weighting, what is the positive / theoretical reason why market weighting is the best choice, in terms of risk adjusted equity returns (let's stick with domestic for this argument)

I understand the counter positive arguments

- why not the market weighted index?
- what is better than the market weighted total index?
- if not market weighting, then what?

I understand the behavioral, in that if your return lags the total market index, you will be tempted to revert to the total market index and permanently lock in historical under performance.

But I'm looking for positive arguments. Why is a total market weighted index the best choice?

Why is it better than an equal weighted index (which is a different animal, more small mid cap and probably more value tilt)

Why is it better than a total market plus tilts?

Ultimarely it doesn’t feel like an index that is 25%, give or take, concentrated in 10 securities feels very diversified.
1. The market is market-cap weighted. (I.e. more of the market's $ is invested in Apple than in Tootsie Roll.) Market-cap weighting allows the market's collective wisdom (or lunacy) to guide one's portfolio.
2. As investors buy and sell, the market produces a return equal to the returns shared by investors as a group.
3. The only way you guarantee yourself that return is by owning a market-cap weighted index fund.
4. If you think you can guarantee (or are willing to risk) yourself a better return, infinite alternatives lie open to you. However, it will be difficult to predict in advance what strategy will yield you better risk-adjusted returns than the market, which is constantly updating its valuation of each stock as buyers buy and sell.
5. If the market-cap portfolio is ever inefficient, it may become efficient very quickly as buyers and sellers figure out the correct price of each security. The market-cap portfolio embraces infinite time horizons. I can buy Apple now because it's safer and buy Southwest now because it's riskier. I will accept the varying returns produced by these two companies, Apple giving me stability now, and Southwest providing a bounce at the end of the year (hopefully). My portfolio is constantly in flux with the market. I trust that the market will figure out the correct price of each security, I expect those prices to rise over time, and I will earn the market's return.
"I am better off than he is – for he knows nothing and thinks that he knows. I neither know nor think that I know." - Socrates. "Nobody knows nothing." - Jack Bogle
acegolfer
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Re: Why is total market weighted index best?

Post by acegolfer »

https://web.archive.org/web/20170826103 ... l.html#arg
To summarize, we first observed that history demonstrates that it is difficult even for professionals to beat the total market. Second, simple arithmetic proves that it is impossible for every investor or even a majority of investors to beat the total market. Third, the theory of how markets work tells us that in order to beat the total market investors either have to be lucky or they have to know something that the market does not already know.
This piece explains the 3 aspects in detail. In addition, it explains why one would want to tilt.
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JoMoney
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Re: Why is total market weighted index best?

Post by JoMoney »

The Warren Buffett parable about "The Gotrocks Family", as included in Bogle's Little Book of Common Sense Investing , explains it in a quaint narrative form:
http://johncbogle.com/wordpress/wp-cont ... %20one.pdf
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Re: Why is total market weighted index best?

Post by nisiprius »

On p. 202 of the 2002 edition of Stocks for the Long Run, Jeremy Siegel wrote:
It can be shown that maximum diversification is achieved by holding each stock in proportion to its value to the entire market.
From the latest (fifth) edition:
To be sure, capitalization-weighted indexes have some very good properties. First, as noted earlier in the chapter, these indexes represent the average dollar-weighted performance of all investors, so that for anyone who does better than the index, someone else must be doing worse. Furthermore, these portfolios, under the assumption of an efficient market, give investors the "best" tradeoff between risk and return. THis means that for any given risk level, these capitalization-weighted portfolios give the highest returns; and for any given return, these portfolios give the lowest risk. This property is called mean-variance efficiency.
To be clear, this is Siegel's' starting point for an assertion that the market is not efficient, and under his own "noisy market hypothesis," his own fundamentally-weighted indexes would be superior. But the point is that cap-weighted indexing is not just some arbitrary choice, it is special.

Another relevant opinion: Eugene Fama is associated with Dimensional Fund Advisors (DFA) and, together with Kenneth R. French, co-authored the seminal papers in 1992 and 1993 that identified the size and value factors and are the underpinnings of factor investing. In a video that was once available on the DFA website, he made this observation:
Interviewer: Some people cite your research showing that value and small firms have higher average returns over time and they assume that you would recommend most investors have a big helping of small and value stocks in their portfolios. Is that a fair representation of your views?

Fama: Um, no. (Laughs) Basically this a risk story the way we tell it, so there is no optimal portfolio. The way I like to talk about it when I give presentations for DFA or other people is, in every asset pricing model, the market portfolio is always an efficient portfolio. It's always a relevant portfolio for an investor to hold. And investors can decide to tilt away from that based on their personal tastes. But that's what it amounts to. You can decide to tilt toward more value or smaller size based on your tastes for these dimensions of risk. But you needn't do it. You could also decide to go the other way. You could look at the premiums and say, no, I think I like the growth stocks better. Then, as long as you get a diversified portfolio of them, I can't argue with that either. So there's a whole multi-dimensional continuum here of efficient portfolios that anybody can decide to buy that I can't quarrel with. And I have no recommendations about because I think it's totally a matter of taste. If you eat oranges and I eat apples I can't really quarrel very much with that.
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MotoTrojan
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Re: Why is total market weighted index best?

Post by MotoTrojan »

I personally don’t feel it is unequivocally. For a long time though the main reason was efficiency as it reduces the need to trade; when Apple doubles in a short time span, it automatically rebalances itself in the market cap index. In an equal weight for example, it would need to trade often. Furthermore, and equal weight index isn’t scalable as not everyone could hold it unless the entire market itself was equal weight. This also means you’re trading a lot of dollars worth of small illiquid companies which will be pricier than a trade on a mega cap.

What’s a middle ground? A fundamental index. Instead of weighting companies based on longterm expected economic scale (which is what market cap is really), it uses current economic scale. While it deviates from market cap weight it still holds more large liquid shares than small, so it’s more scalable and efficient. It does tilt to value dynamically (worse value has done more it holds, worse growth has done the more it holds).

Most interesting to me is that it avoids market cap’s greatest flaw, it’s link to price, which by design means if a company turns out to be overvalued it will have overweighted it today, and if it was undervalued it will hold less. This IMHO is a drag on returns.

These strategies really only make sense now in the age of ETFs where the extra trading is free of capital gains distributions. I hold a fair amount of my US large in these (FNDX) and all my ex-US (FNDC, a small cap dev market fund). I also use more traditional US small value funds and some other concentrated value offerings. So I’m not a market capper in the slightest, even though my 401k is mostly made up of VTSAX.

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Re: Why is total market weighted index best?

Post by rascott »

The cap weighted portfolio is the market. For you to tilt away from it means that someone else is tilting away from it in the opposite manner. For you to "win" (beat the market) another investor has to lose (underperform the market).

Anything other than total market cap weighting is in effect a form of stock picking. I have tilts to smaller caps and a bit of value. So I'm not a pure practitioner. But over time I'm slowly trending back towards market cap weighting. In many ways coming full circle back to a belief in it.
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Re: Why is total market weighted index best?

Post by MotoTrojan »

rascott wrote: Wed May 13, 2020 8:40 am The cap weighted portfolio is the market. For you to tilt away from it means that someone else is tilting away from it in the opposite manner. For you to "win" (beat the market) another investor has to lose (underperform the market).

Anything other than total market cap weighting is in effect a form of stock picking. I have tilts to smaller caps and a bit of value. So I'm not a pure practitioner. But over time I'm slowly trending back towards market cap weighting. In many ways coming full circle back to a belief in it.
Just because it’s the market doesn’t mean it’s right.
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Re: Why is total market weighted index best?

Post by whereskyle »

rascott wrote: Wed May 13, 2020 8:40 am The cap weighted portfolio is the market. For you to tilt away from it means that someone else is tilting away from it in the opposite manner. For you to "win" (beat the market) another investor has to lose (underperform the market).

Anything other than total market cap weighting is in effect a form of stock picking. I have tilts to smaller caps and a bit of value. So I'm not a pure practitioner. But over time I'm slowly trending back towards market cap weighting. In many ways coming full circle back to a belief in it.
I believe Ferri has said the life of a total-market indexer has a cycle, and one of the parts of that cycle is to stray from the market portfolio by overcomplicating it. I have strayed a bit recently, and I blame myself as much as I blame the covid crash. Any serious market drop makes it seem easy to pick stocks if the drop results in blue chips priced at a 35% discount. But as the market has risen, and the blue chips have become as pricey as they've ever been once again, I am less and less convinced I should pick "good" stocks and have reverted to buying VTI and VT. When the decisions become more difficult, I can't see how buying something apart from the market decreases my risk while increasing my expected return.
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whereskyle
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Re: Why is total market weighted index best?

Post by whereskyle »

MotoTrojan wrote: Wed May 13, 2020 8:47 am
rascott wrote: Wed May 13, 2020 8:40 am The cap weighted portfolio is the market. For you to tilt away from it means that someone else is tilting away from it in the opposite manner. For you to "win" (beat the market) another investor has to lose (underperform the market).

Anything other than total market cap weighting is in effect a form of stock picking. I have tilts to smaller caps and a bit of value. So I'm not a pure practitioner. But over time I'm slowly trending back towards market cap weighting. In many ways coming full circle back to a belief in it.
Just because it’s the market doesn’t mean it’s right.
What could be better? You can always take more risk, but no one can tell you in advance whether such an approach will bear fruit. Hard to disagree that the market portfolio is always an acceptable and reasonable choice. What could be more "right" than an always acceptable and reasonable choice?
"I am better off than he is – for he knows nothing and thinks that he knows. I neither know nor think that I know." - Socrates. "Nobody knows nothing." - Jack Bogle
Blue456
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Re: Why is total market weighted index best?

Post by Blue456 »

JBTX wrote: Tue May 12, 2020 10:37 pm While I totally buy into indexing, and generally buy into market weighting, what is the positive / theoretical reason why market weighting is the best choice, in terms of risk adjusted equity returns (let's stick with domestic for this argument)
Ehhh.... I don't put all my eggs into market weight basket. I will be either partially wrong or partially right and this will be good enough to me.
magicrat
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Re: Why is total market weighted index best?

Post by magicrat »

Because I prefer to have the same % ownership stake in every company I own, instead of making active bets and increasing my ownership stake in some companies.
MotoTrojan
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Re: Why is total market weighted index best?

Post by MotoTrojan »

whereskyle wrote: Wed May 13, 2020 8:50 am
MotoTrojan wrote: Wed May 13, 2020 8:47 am
rascott wrote: Wed May 13, 2020 8:40 am The cap weighted portfolio is the market. For you to tilt away from it means that someone else is tilting away from it in the opposite manner. For you to "win" (beat the market) another investor has to lose (underperform the market).

Anything other than total market cap weighting is in effect a form of stock picking. I have tilts to smaller caps and a bit of value. So I'm not a pure practitioner. But over time I'm slowly trending back towards market cap weighting. In many ways coming full circle back to a belief in it.
Just because it’s the market doesn’t mean it’s right.
What could be better? You can always take more risk, but no one can tell you in advance whether such an approach will bear fruit. Hard to disagree that the market portfolio is always an acceptable and reasonable choice. What could be more "right" than an always acceptable and reasonable choice?
Would using a RAFI index which weights based on current economic output/scale not also be an “acceptable and reasonable” choice? I didn’t say market weight was wrong, just that it doesn’t automatically win simply because it is the entire market. Humans can be irrational. I’m not saying I know the answer, just that the particular rationale here is imho not sufficient.
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Re: Why is total market weighted index best?

Post by tibbitts »

MotoTrojan wrote: Wed May 13, 2020 8:54 am
whereskyle wrote: Wed May 13, 2020 8:50 am
MotoTrojan wrote: Wed May 13, 2020 8:47 am
rascott wrote: Wed May 13, 2020 8:40 am The cap weighted portfolio is the market. For you to tilt away from it means that someone else is tilting away from it in the opposite manner. For you to "win" (beat the market) another investor has to lose (underperform the market).

Anything other than total market cap weighting is in effect a form of stock picking. I have tilts to smaller caps and a bit of value. So I'm not a pure practitioner. But over time I'm slowly trending back towards market cap weighting. In many ways coming full circle back to a belief in it.
Just because it’s the market doesn’t mean it’s right.
What could be better? You can always take more risk, but no one can tell you in advance whether such an approach will bear fruit. Hard to disagree that the market portfolio is always an acceptable and reasonable choice. What could be more "right" than an always acceptable and reasonable choice?
Would using a RAFI index which weights based on current economic output/scale not also be an “acceptable and reasonable” choice? I didn’t say market weight was wrong, just that it doesn’t automatically win simply because it is the entire market. Humans can be irrational. I’m not saying I know the answer, just that the particular rationale here is imho not sufficient.
Absolutely it would be, it's just that there's a slipperly slope of how to evaluate "current economic output/scale."
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Re: Why is total market weighted index best?

Post by rascott »

MotoTrojan wrote: Wed May 13, 2020 8:47 am
rascott wrote: Wed May 13, 2020 8:40 am The cap weighted portfolio is the market. For you to tilt away from it means that someone else is tilting away from it in the opposite manner. For you to "win" (beat the market) another investor has to lose (underperform the market).

Anything other than total market cap weighting is in effect a form of stock picking. I have tilts to smaller caps and a bit of value. So I'm not a pure practitioner. But over time I'm slowly trending back towards market cap weighting. In many ways coming full circle back to a belief in it.
Just because it’s the market doesn’t mean it’s right.

While true...... it also requires you to not only pick how the market is wrong.... but also when it's wrong. And then what exactly to do about it.

I read Bogle's writings roughly 20 years ago and they made complete sense (investors as a group will get the returns of the market minus fees) ... but I also was a finance guy and always assumed that just more in- depth research would unearth the holy grail... the "better than market" portfolio. After 20 years of digging and trying.....I get closer to throwing in the towel every year.... and bow down and say Jack, yeah man, you were right. Beating the market over a very long period (lifetime) seems somewhere between improbable and impossible.

I think I'd rather mildly leverage the market portfolio if I wanted higher risk/ returns over slicing and dicing. I'll continue to hold my tilts as they are a lifelong commitment.... and I'm committed. But doesn't mean I was right.
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David Jay
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Re: Why is total market weighted index best?

Post by David Jay »

DonIce wrote: Wed May 13, 2020 1:36 amIt's more like a solid default option that should minimize regret for most people.
I really like this language. (expect me to steal and re-use shamelessly)
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Re: Why is total market weighted index best?

Post by whereskyle »

MotoTrojan wrote: Wed May 13, 2020 8:54 am
whereskyle wrote: Wed May 13, 2020 8:50 am
MotoTrojan wrote: Wed May 13, 2020 8:47 am
rascott wrote: Wed May 13, 2020 8:40 am The cap weighted portfolio is the market. For you to tilt away from it means that someone else is tilting away from it in the opposite manner. For you to "win" (beat the market) another investor has to lose (underperform the market).

Anything other than total market cap weighting is in effect a form of stock picking. I have tilts to smaller caps and a bit of value. So I'm not a pure practitioner. But over time I'm slowly trending back towards market cap weighting. In many ways coming full circle back to a belief in it.
Just because it’s the market doesn’t mean it’s right.
What could be better? You can always take more risk, but no one can tell you in advance whether such an approach will bear fruit. Hard to disagree that the market portfolio is always an acceptable and reasonable choice. What could be more "right" than an always acceptable and reasonable choice?
Would using a RAFI index which weights based on current economic output/scale not also be an “acceptable and reasonable” choice? I didn’t say market weight was wrong, just that it doesn’t automatically win simply because it is the entire market. Humans can be irrational. I’m not saying I know the answer, just that the particular rationale here is imho not sufficient.
Such an index is simply another attempt to beat the market by using a formula to "pick" (or weight) stocks. 50% chance it outperforms, 50% chance it underperforms, just like any other attempt (well thought out, quantitatively supported, entirely random stock-picking, or otherwise) to beat the market. I think the most sensible choice is not to try to pick stocks by doubting the market's view of what the prices should be, which increases risk (and stress), and which pits the investor (or in this instance, the game-player) against the market in a battle of speculation. Sometimes this extra risk pays off. Sometimes it does not. And absolutely no one can tell you in advance whether it will. I personally see no measurable benefit to taking on that additional risk, so I generally don't take it.

I am interested in whether one could possibly explain whether holding a portfolio other than the market-cap weighted, total-market portfolio is ever less risky. For instance, VDC (Vanguard Consumer Staples ETF, ER.10) has for about 15 years provided U.S.-market-beating, higher risk-adjusted returns. Can we now say that VDC is less risky than VTI?

Jack, I think, admitted that his theory is tautological. No one can show that he is wrong. We'd all probably find him very annoying if he didn't make us so much money.
Last edited by whereskyle on Wed May 13, 2020 9:49 am, edited 1 time in total.
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Re: Why is total market weighted index best?

Post by David Jay »

DonIce wrote: Wed May 13, 2020 1:49 am
JBTX wrote: Wed May 13, 2020 1:40 am thanks for the replies.

To take it a step further. There is a negligible difference between total market index and s&p 500. Thus the bottom 4500 (or whatever the real number is) are essentially irrelevant. By extension, it is better to own the top 10-15 companies vs the bottom 4500.
Taking it down to 10-15 is probably too few. But the top ~30 is close enough, as can be seen by the correlation between the Dow and the S&P500.
Owning the top 30 will give you a "similar" performance to the SP500, not a "better" performance. And then you are responsible to manage the portfolio (almost certainly the last few stocks - say number 28, 29 and 30 - will change regularly as, say, company 32 grows or company 28 shrinks), decide on the time-frame for swapping the rotating stocks, etc. So where is the value to you as an investor? Why not buy VOO or SPY?
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Re: Why is total market weighted index best?

Post by jibantik »

TheDDC wrote: Wed May 13, 2020 1:01 am
JBTX wrote: Tue May 12, 2020 10:37 pm While I totally buy into indexing, and generally buy into market weighting, what is the positive / theoretical reason why market weighting is the best choice, in terms of risk adjusted equity returns (let's stick with domestic for this argument)

I understand the counter positive arguments

- why not the market weighted index?
- what is better than the market weighted total index?
- if not market weighting, then what?

I understand the behavioral, in that if your return lags the total market index, you will be tempted to revert to the total market index and permanently lock in historical under performance.

But I'm looking for positive arguments. Why is a total market weighted index the best choice?

Why is it better than an equal weighted index (which is a different animal, more small mid cap and probably more value tilt)

Why is it better than a total market plus tilts?

Ultimarely it doesn’t feel like an index that is 25%, give or take, concentrated in 10 securities feels very diversified.
I chose to market cap weight (VTSAX) but have shifted half of my domestic allocation to Vanguard growth index (VIGAX) about two weeks ago. I do not believe a passive index alone is always 100% the way to go.

...

-TheDDC
VTSAX is decidedly not market weight. It only holds US, so is missing a lot of the market. VTWAX is market weight.
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Re: Why is total market weighted index best?

Post by wickywack »

JBTX wrote: Tue May 12, 2020 10:37 pm But I'm looking for positive arguments. Why is a total market weighted index the best choice?

Why is it better than an equal weighted index (which is a different animal, more small mid cap and probably more value tilt)
This isn't a theoretical answer - just a personal mental exercise I've done. I may be overlooking something too. :-)

Suppose you own some amount of Alphabet stock as part of your overall allocation. Suppose Alphabet suddenly decides to split into its current ~15 or so subsidiaries (Google, Fiber, Loon, Verily, Waymo, ...). I.e., one public company to ~15.

What would you do?

An equal weighted approach would now increase your total allocation to the Alphabet companies by nearly 15x, selling off other holdings to make that happen. You'd be now investing the same in Loon (internet via high altitude balloons) as Google (or basically the original Alphabet).

A market weighted approach would do nothing. Each Alphabet share would naturally split off into their respective subsidiary shares at a market weight. The vast majority of your initial Alphabet investment presumably continues as a Google investment. Your overall investment doesn't change, though the market may price the combination differently going forward.

Those aren't the only two answers of course. But if you are considering other options, you might also think about how they'd handle the same situation (or, correspondingly, a merger) and whether that feels intuitive to you.
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Re: Why is total market weighted index best?

Post by acegolfer »

jibantik wrote: Wed May 13, 2020 9:52 am VTSAX is decidedly not market weight. It only holds US, so is missing a lot of the market. VTWAX is market weight.
MKT factor in FF model is US CRSP Value weighted. When Fama says market ptf is always efficient, he means TSM not world cap.
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Re: Why is total market weighted index best?

Post by JBTX »

wickywack wrote: Wed May 13, 2020 9:55 am
JBTX wrote: Tue May 12, 2020 10:37 pm But I'm looking for positive arguments. Why is a total market weighted index the best choice?

Why is it better than an equal weighted index (which is a different animal, more small mid cap and probably more value tilt)
This isn't a theoretical answer - just a personal mental exercise I've done. I may be overlooking something too. :-)

Suppose you own some amount of Alphabet stock as part of your overall allocation. Suppose Alphabet suddenly decides to split into its current ~15 or so subsidiaries (Google, Fiber, Loon, Verily, Waymo, ...). I.e., one public company to ~15.

What would you do?

An equal weighted approach would now increase your total allocation to the Alphabet companies by nearly 15x, selling off other holdings to make that happen. You'd be now investing the same in Loon (internet via high altitude balloons) as Google (or basically the original Alphabet).

A market weighted approach would do nothing. Each Alphabet share would naturally split off into their respective subsidiary shares at a market weight. The vast majority of your initial Alphabet investment presumably continues as a Google investment. Your overall investment doesn't change, though the market may price the combination differently going forward.

Those aren't the only two answers of course. But if you are considering other options, you might also think about how they'd handle the same situation (or, correspondingly, a merger) and whether that feels intuitive to you.
This is actually a good answer at least from a logical perspective. The equal weight would suffer some of the same arbitrary characteristics as the Dow, and if this index were prominent it would incentivise companies to break up.

I only used equal weight as an example of something else, but as you point out it is particularly arbitrary.
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Re: Why is total market weighted index best?

Post by Northern Flicker »

JBTX wrote: Wed May 13, 2020 1:40 am thanks for the replies.

To take it a step further. There is a negligible difference between total market index and s&p 500. Thus the bottom 4500 (or whatever the real number is) are essentially irrelevant. By extension, it is better to own the top 10-15 companies vs the bottom 4500.
When you pare it down to 10-15 companies, you have an undiversified portfolio which is inferior to the S&P500 or total market index on account of uncompensated concentration risk.

The transaction cost of maintaining membership in the S&P500 across index changes is an uncompensated overhead, so it is reasonable to believe that the expected risk-adjusted return of the total market index is very slightly higher than for the S&P500.

Also, the total US market indices are closer to 3500 stocks these days, not 5000.
Risk is not a guarantor of return.
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Re: Why is total market weighted index best?

Post by JBTX »

Northern Flicker wrote: Wed May 13, 2020 4:13 pm
JBTX wrote: Wed May 13, 2020 1:40 am thanks for the replies.

To take it a step further. There is a negligible difference between total market index and s&p 500. Thus the bottom 4500 (or whatever the real number is) are essentially irrelevant. By extension, it is better to own the top 10-15 companies vs the bottom 4500.
When you pare it down to 10-15 companies, you have an undiversified portfolio which is inferior to the S&P500 or total market index on account of uncompensated concentration risk.

The transaction cost of maintaining membership in the S&P500 across index changes is an uncompensated overhead, so it is reasonable to believe that the expected risk-adjusted return of the total market index is very slightly higher than for the S&P500.

Also, the total US market indices are closer to 3500 stocks these days, not 5000.
I guess my point is the diversification impact of 3400 of 3500 companies is rounding error due to the concentration of the index.
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Re: Why is total market weighted index best?

Post by rascott »

JBTX wrote: Wed May 13, 2020 4:37 pm
Northern Flicker wrote: Wed May 13, 2020 4:13 pm
JBTX wrote: Wed May 13, 2020 1:40 am thanks for the replies.

To take it a step further. There is a negligible difference between total market index and s&p 500. Thus the bottom 4500 (or whatever the real number is) are essentially irrelevant. By extension, it is better to own the top 10-15 companies vs the bottom 4500.
When you pare it down to 10-15 companies, you have an undiversified portfolio which is inferior to the S&P500 or total market index on account of uncompensated concentration risk.

The transaction cost of maintaining membership in the S&P500 across index changes is an uncompensated overhead, so it is reasonable to believe that the expected risk-adjusted return of the total market index is very slightly higher than for the S&P500.

Also, the total US market indices are closer to 3500 stocks these days, not 5000.
I guess my point is the diversification impact of 3400 of 3500 companies is rounding error due to the concentration of the index.
Only in the short run.

How many of those top 10 firms were in the top 10, 25 years ago?

Did that hold back the investor in the SP500?

I'm assuming you care about your returns over the next several decades.
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Re: Why is total market weighted index best?

Post by pascalwager »

TheDDC wrote: Wed May 13, 2020 1:01 am
JBTX wrote: Tue May 12, 2020 10:37 pm While I totally buy into indexing, and generally buy into market weighting, what is the positive / theoretical reason why market weighting is the best choice, in terms of risk adjusted equity returns (let's stick with domestic for this argument)

I understand the counter positive arguments

- why not the market weighted index?
- what is better than the market weighted total index?
- if not market weighting, then what?

I understand the behavioral, in that if your return lags the total market index, you will be tempted to revert to the total market index and permanently lock in historical under performance.

But I'm looking for positive arguments. Why is a total market weighted index the best choice?

Why is it better than an equal weighted index (which is a different animal, more small mid cap and probably more value tilt)

Why is it better than a total market plus tilts?

Ultimarely it doesn’t feel like an index that is 25%, give or take, concentrated in 10 securities feels very diversified.
I chose to market cap weight (VTSAX) but have shifted half of my domestic allocation to Vanguard growth index (VIGAX) about two weeks ago. I do not believe a passive index alone is always 100% the way to go. While I am bullish on a recovery, quite possibly occurring by end of year, I believe that growth stocks will lead the way. In making this decision I did not consider the current circumstance in isolation. For most decades, growth has led the way.

I will continue to reassess, but considering VTI/VTSAX is also categorized as “large growth” on the style matrix or even “growth+income”, tiling toward growth a tad more is not veering too bad off the path in my view. It’s not like piling it all in the cubes.

-TheDDC
Since 1972, US large growth and US stock market have produced almost identical returns as shown on PV.

VTSAX is categorized as large blend by Vanguard and M*, not large growth.

The way you've explained it, your portfolio change seems like market timing and making a bet on large growth as opposed to just holding the market.
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Re: Why is total market weighted index best?

Post by bertilak »

MotoTrojan wrote: Wed May 13, 2020 8:47 am
rascott wrote: Wed May 13, 2020 8:40 am The cap weighted portfolio is the market. For you to tilt away from it means that someone else is tilting away from it in the opposite manner. For you to "win" (beat the market) another investor has to lose (underperform the market).

Anything other than total market cap weighting is in effect a form of stock picking. I have tilts to smaller caps and a bit of value. So I'm not a pure practitioner. But over time I'm slowly trending back towards market cap weighting. In many ways coming full circle back to a belief in it.
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But it does mean that if you think otherwise you have some "splainin" to do!
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Re: Why is total market weighted index best?

Post by ruud »

wickywack wrote: Wed May 13, 2020 9:55 am This isn't a theoretical answer - just a personal mental exercise I've done. I may be overlooking something too. :-)

Suppose you own some amount of Alphabet stock as part of your overall allocation. Suppose Alphabet suddenly decides to split into its current ~15 or so subsidiaries (Google, Fiber, Loon, Verily, Waymo, ...). I.e., one public company to ~15.

What would you do?

An equal weighted approach would now increase your total allocation to the Alphabet companies by nearly 15x, selling off other holdings to make that happen. You'd be now investing the same in Loon (internet via high altitude balloons) as Google (or basically the original Alphabet).

A market weighted approach would do nothing. Each Alphabet share would naturally split off into their respective subsidiary shares at a market weight. The vast majority of your initial Alphabet investment presumably continues as a Google investment. Your overall investment doesn't change, though the market may price the combination differently going forward.

Those aren't the only two answers of course. But if you are considering other options, you might also think about how they'd handle the same situation (or, correspondingly, a merger) and whether that feels intuitive to you.
Another, similar, paradox: with cap weighting it doesn't really matter how many stocks you include once you pass some threshold, as witnessed by the similar returns of S&P 500 and Total Market. Wherever you draw the line (somewhere between 100 and 3500 stocks), the weight of Microsoft will end up somewhere around 5%.

However, with equal weight index you have to consciously draw a line somewhere on how many stocks you want to include. If you pick 100, Microsoft has a weight of 1%, but if you pick 500, Microsoft has a weight of 0.2%. And if you pick 3500 stocks, then Microsoft would have a weight of 0.03%.

This makes equal weight indexing seem very "arbitrary" to me.
.
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Re: Why is total market weighted index best?

Post by BH+ »

A broad-based capitalization index lets you capture the returns and ride the momentum of all the long-term winners in the market. You don't have to find the needle in the haystack. It will rise to the top. I don't know if that is definitively the best in terms of risk and return, but in terms of portfolio construction, taxes and fees it is the best we've got.
Last edited by BH+ on Wed May 13, 2020 8:39 pm, edited 1 time in total.
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Re: Why is total market weighted index best?

Post by nisiprius »

Three fund companies introduced "fundamental indexing" products at about the same time around 2006-2007. All of them depart from cap-weighting in rules-based ways that take account of business fundamentals. The stories behind all of them sounded highly plausible, and certainly none of them have been disasters for investors that held them. Nevertheless, starting at inception of the Fidelity Large Cap Enhanced Index fund, to date not a single one of them has outperformed the (cap-weighted) Vanguard 500 Index Fund. All three of them disappointed.

Total growth of a $10,000 investment 4/19/2007 (inception of FLCEX) through 5/13/2020:

WisdomTree US LargeCap Dividend, DLN: $21,236.04, orange. (WisdomTree's senior investment strategy advisor is Jeremy Siegel, author of "Stocks for the Long Run")

Schwab Fundamental US Large Company, SFLNX, $22,360.35, green (Tracks the Russell RAFI US Large Company Index, RAFI being an index designed by Rob Arnott's firm and Rob Arnott being a well-known advocate of fundamental indexing).

Fidelity Large-Cap Enhanced Index, FCLEX, green, $24,577.17.

Plain old cap-weighted Vanguard 500 Index, VFIAX, yellow, $25,250.67.

It would seem to be common sense that you could improve on cap-weighting by incorporating a tilt to stocks that have better fundamentals, but it isn't as easy to do as it seems.

Source

Image
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Triple digit golfer
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Re: Why is total market weighted index best?

Post by Triple digit golfer »

If Microsoft is valued at $1.3 trillion and TDG's Pro Shop is valued at $1.3 million, I believe in investing a million times more in Microsoft.

I believe that many of the largest companies could very easily be multiple companies. TDG's Pro Shop is just a small golf equipment retailer. Microsoft is, well, Microsoft. They're absolutely enormous. Why would I invest the same amount in each company in the name if diversification when in reality, concentrating the same amount in TDG's Pro Shop as Microsoft is a huge bet on a tiny company, relatively speaking.
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Re: Why is total market weighted index best?

Post by averagedude »

Really don't know which will outperform in the future, but market cap weighting follows the principals of the efficient market hypothesis. This is enough reason for me to choose it.
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Re: Why is total market weighted index best?

Post by JoMoney »

averagedude wrote: Wed May 13, 2020 9:36 pm Really don't know which will outperform in the future, but market cap weighting follows the principals of the efficient market hypothesis. This is enough reason for me to choose it.
I don't believe in the "efficient market hypothesis", but I choose a low-cost market cap fund because I know that I don't have better information than other market participants.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham
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Re: Why is total market weighted index best?

Post by JoMoney »

BH+ wrote: Wed May 13, 2020 7:01 pm A broad-based capitalization index lets you capture the returns and ride the momentum of all the long-term winners in the market. You don't have to find the needle in the haystack. It will rise to the top. I don't know if that is definitively the best in terms of risk and return, but in terms of portfolio construction, taxes and fees it is the best we've got.
When I hear the 'fundamental indexers' complain that cap-weighted funds are too heavy in the over-priced stocks, I like to consider that means when I go into a withdrawal phase I'll be selling a higher weighting of the overpriced stocks. :mrgreen:
How do they imagine they ever get ahead if the stocks they're buying are persistently under-priced? :P
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham
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Re: Why is total market weighted index best?

Post by BH+ »

JoMoney wrote: Wed May 13, 2020 10:04 pm
BH+ wrote: Wed May 13, 2020 7:01 pm A broad-based capitalization index lets you capture the returns and ride the momentum of all the long-term winners in the market. You don't have to find the needle in the haystack. It will rise to the top. I don't know if that is definitively the best in terms of risk and return, but in terms of portfolio construction, taxes and fees it is the best we've got.
When I hear the 'fundamental indexers' complain that cap-weighted funds are too heavy in the over-priced stocks, I like to consider that means when I go into a withdrawal phase I'll be selling a higher weighting of the overpriced stocks. :mrgreen:
How do they imagine they ever get ahead if the stocks they're buying are persistently under-priced? :P
That's a very good way to look at it.
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Re: Why is total market weighted index best?

Post by MotoTrojan »

nisiprius wrote: Wed May 13, 2020 8:30 pm Three fund companies introduced "fundamental indexing" products at about the same time around 2006-2007. All of them depart from cap-weighting in rules-based ways that take account of business fundamentals. The stories behind all of them sounded highly plausible, and certainly none of them have been disasters for investors that held them. Nevertheless, starting at inception of the Fidelity Large Cap Enhanced Index fund, to date not a single one of them has outperformed the (cap-weighted) Vanguard 500 Index Fund. All three of them disappointed.

Total growth of a $10,000 investment 4/19/2007 (inception of FLCEX) through 5/13/2020:

WisdomTree US LargeCap Dividend, DLN: $21,236.04, orange. (WisdomTree's senior investment strategy advisor is Jeremy Siegel, author of "Stocks for the Long Run")

Schwab Fundamental US Large Company, SFLNX, $22,360.35, green (Tracks the Russell RAFI US Large Company Index, RAFI being an index designed by Rob Arnott's firm and Rob Arnott being a well-known advocate of fundamental indexing).

Fidelity Large-Cap Enhanced Index, FCLEX, green, $24,577.17.

Plain old cap-weighted Vanguard 500 Index, VFIAX, yellow, $25,250.67.

It would seem to be common sense that you could improve on cap-weighting by incorporating a tilt to stocks that have better fundamentals, but it isn't as easy to do as it seems.

Source

Image
You frequently pop these charts up explaining how these funds failed to meet their objective because they didn’t best a total market index, but I personally think the data is just screaming success. Since inception the Schwab fund has held its own with the market with a healthy HML loading during a time that growth significantly outperformed; its HML was on par with market cap weight large-value funds yet avoided the >1% negative alpha they experienced. Maybe the benchmark/marketing isn’t perfect but when you look at the theory of what these indexes are intended to do they have excelled. During growth outperformance periods they hang just behind the market, and when value has its moment to shine they take the lead.
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Re: Why is total market weighted index best?

Post by MotoTrojan »

BH+ wrote: Wed May 13, 2020 11:48 pm
JoMoney wrote: Wed May 13, 2020 10:04 pm
BH+ wrote: Wed May 13, 2020 7:01 pm A broad-based capitalization index lets you capture the returns and ride the momentum of all the long-term winners in the market. You don't have to find the needle in the haystack. It will rise to the top. I don't know if that is definitively the best in terms of risk and return, but in terms of portfolio construction, taxes and fees it is the best we've got.
When I hear the 'fundamental indexers' complain that cap-weighted funds are too heavy in the over-priced stocks, I like to consider that means when I go into a withdrawal phase I'll be selling a higher weighting of the overpriced stocks. :mrgreen:
How do they imagine they ever get ahead if the stocks they're buying are persistently under-priced? :P
That's a very good way to look at it.
I think a higher CAGR over an investing lifetime would more than makeup for this admittedly funny way of looking at things. That’s what a tilting is hoping for at least.
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Re: Why is total market weighted index best?

Post by dcabler »

JBTX wrote: Tue May 12, 2020 10:37 pm While I totally buy into indexing, and generally buy into market weighting, what is the positive / theoretical reason why market weighting is the best choice, in terms of risk adjusted equity returns (let's stick with domestic for this argument)

I understand the counter positive arguments

- why not the market weighted index?
- what is better than the market weighted total index?
- if not market weighting, then what?

I understand the behavioral, in that if your return lags the total market index, you will be tempted to revert to the total market index and permanently lock in historical under performance.

But I'm looking for positive arguments. Why is a total market weighted index the best choice?

Why is it better than an equal weighted index (which is a different animal, more small mid cap and probably more value tilt)

Why is it better than a total market plus tilts?

Ultimarely it doesn’t feel like an index that is 25%, give or take, concentrated in 10 securities feels very diversified.
Best choice? In an absolute sense, I don't think so. Not because I have anything against it, but simply because "best" is unknowable beforehand. Suitable for many people, yes. Fits with many investor's personal philosophies on investing, sure. Available cheaply and and in a tax efficient manner? Check and check. In a universe of investing choices, it is but one.
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Re: Why is total market weighted index best?

Post by Northern Flicker »

JBTX wrote: Wed May 13, 2020 4:37 pm
Northern Flicker wrote: Wed May 13, 2020 4:13 pm
JBTX wrote: Wed May 13, 2020 1:40 am thanks for the replies.

To take it a step further. There is a negligible difference between total market index and s&p 500. Thus the bottom 4500 (or whatever the real number is) are essentially irrelevant. By extension, it is better to own the top 10-15 companies vs the bottom 4500.
When you pare it down to 10-15 companies, you have an undiversified portfolio which is inferior to the S&P500 or total market index on account of uncompensated concentration risk.

The transaction cost of maintaining membership in the S&P500 across index changes is an uncompensated overhead, so it is reasonable to believe that the expected risk-adjusted return of the total market index is very slightly higher than for the S&P500.

Also, the total US market indices are closer to 3500 stocks these days, not 5000.
I guess my point is the diversification impact of 3400 of 3500 companies is rounding error due to the concentration of the index.
Owning the top 100 or more would be acceptable. It would not be my choice, but it is more or less diversified adequately. I think it may at times have more sector concentration than the S&P500. The CRSP megacap index is tracked by the fund MGC which I think holds 250 or 260 stocks.

But 10-15 is not enough and should not be casually considered to be roughly equivalent to holding 100 or more. Diversifying away unsystematic risk is not a rounding error.

And I’m not sure 100 stocks is enough to diversify concentration risk when the portfolio is cap-weighted. One point of the total market is that only 80% of it is the S&P500 so that the extended market dilutes the concentration of the largest holdings, but by maintaining the portfolio as cap-weighted, the stocks are held in approximate proportion to their liquidity, which is an important, under-appreciated benefit of market index funds.
Risk is not a guarantor of return.
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Re: Why is total market weighted index best?

Post by JBTX »

Northern Flicker wrote: Thu May 14, 2020 4:46 pm
JBTX wrote: Wed May 13, 2020 4:37 pm
Northern Flicker wrote: Wed May 13, 2020 4:13 pm
JBTX wrote: Wed May 13, 2020 1:40 am thanks for the replies.

To take it a step further. There is a negligible difference between total market index and s&p 500. Thus the bottom 4500 (or whatever the real number is) are essentially irrelevant. By extension, it is better to own the top 10-15 companies vs the bottom 4500.
When you pare it down to 10-15 companies, you have an undiversified portfolio which is inferior to the S&P500 or total market index on account of uncompensated concentration risk.

The transaction cost of maintaining membership in the S&P500 across index changes is an uncompensated overhead, so it is reasonable to believe that the expected risk-adjusted return of the total market index is very slightly higher than for the S&P500.

Also, the total US market indices are closer to 3500 stocks these days, not 5000.
I guess my point is the diversification impact of 3400 of 3500 companies is rounding error due to the concentration of the index.
Owning the top 100 or more would be acceptable. It would not be my choice, but it is more or less diversified adequately. I think it may at times have more sector concentration than the S&P500. The CRSP megacap index is tracked by the fund MGC which I think holds 250 or 260 stocks.

But 10-15 is not enough and should not be casually considered to be roughly equivalent to holding 100 or more. Diversifying away unsystematic risk is not a rounding error.

And I’m not sure 100 stocks is enough to diversify concentration risk when the portfolio is cap-weighted. One point of the total market is that only 80% of it is the S&P500 so that the extended market dilutes the concentration of the largest holdings, but by maintaining the portfolio as cap-weighted, the stocks are held in approximate proportion to their liquidity, which is an important, under-appreciated benefit of market index funds.
if the s&p 500 and TSM deliver almost exactly the same return, then the extended market diversification impact is negligible. That is kind of my point.
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Re: Why is total market weighted index best?

Post by Northern Flicker »

I don’t think the total market offers a dramatic benefit over the S&P500, and some even prefer just holding the S&P500. But returns could be identical and one could still offer an improved diversification over the other. The main purpose of diversification is to reduce risk or improve risk-adjusted return.
Risk is not a guarantor of return.
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Re: Why is total market weighted index best?

Post by Phineas J. Whoopee »

MotoTrojan wrote: Wed May 13, 2020 8:47 am ...
Just because it’s the market doesn’t mean it’s right.
What's the market-external standard for what is right?

PJW
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